If recent market action in previous years is any indication, it’s fairly obvious that more volatility in the markets is likely to be seen in the near future. Whether it is the major crash in 2008 where stocks lost around 50% of its value or days like the May 6th “flash crash” where the Dow Jones dropped 1000 points in a matter of minutes, the stock market is hardly tame place these days.
Unfortunately, the market make-up and how it functions today is pushing it to a more volatile state. 70% of the stock market volume is now controlled by computers trading stocks – why this is allowed is another discussion, but high-frequency trading that trades stocks back and forth millions of times per second hardly is important for a well-functioning capital market that promotes economic activity and growth. Because of the computers doing most of the trading, we’re very susceptible for serious volatility which is what we saw in the “flash crash” of May 6, 2010.
We have to be ready for more volatility and protect our assets from future market crashes, whether they are driven by economic data or computer algorithms gone haywire.
How can you protect your portfolio?
Consider the following:
- Make sure most of your stocks are paying dividends - the higher the yield the better. Dividend payouts represent the only reason to own stocks over the long term. Cash payouts when paid out are the only aspect of your portfolio not at risk anymore. You want a high cash flowing portfolio. Focus on dividend stocks with a long track record of increasing dividends over the years.
- Construct a long/short portfolio versus a long-only portfolio. A long / short portfolio includes short positions to hedge against broad market losses that will definitely impact your long positions. Based on the economic environment, it is maybe a good strategy to short companies that are very susceptible to a struggling economy or lower consumer spending. Make sure your long positions are recession-resistant and pay dividends. The combination of long/short positions should provide some better protection.
- Consider insurance against a real crash - While the short positions will offer some hedging against a down market, there is another low cost option to insure against a major crash. What I’m talking abou there is the volatility index or the VIX. You can buy cheap, VIX calls that are months out that will explode in value if the market crashes. FOr reference, the VIX is currently about 25ish (August 2010). At the height of the crash in 2008, the VIX was up to 90. VIX calls would explode in value if the VIX shot up that high again and you could literally turn a few hundred bucks into several tens of thousands. Now, this is a remote event, but again this is insurance.
This is no longer a time to ignore stock market activity because we buy into the idea that stocks are always sound as long as our time horizon is long enough. Can you afford another crash and loss of half the value of your assets? I can’t. It’s important to prepare for a market crash and protect against it. You can still find returns in this environment, but you need to focus on capital preservation above all else.